By Scott Evans, Spring 2014 Student Intern
What is a Bond?
While most investors have heard of bonds, they might struggle to define the term. Simply put, bonds are loans. These loans are made on behalf of investors to an entity such as the United States government, a local government, or a corporation to enable that entity to fund a project. In return for these loans, investors earn interest on their investments from the entity receiving the loans. Most bonds are for a predetermined amount of time, and once that time elapses, the borrowing entity repays the principal, or the amount lent to the original investor.
When dealing with bonds, certain key phrases will appear. These definitions will help you decode some basic details of bonds. To provide further assistance, consider this example as you go down the list: An investor pays $100 for a bond with 5% annual interest. The bond’s term is for one year, and the bond is callable prior to maturity for $110.
- Principal: An investor’s original investment. In the example, the principal is simply $100.
- Coupon/Coupon rate: The interest an investor receives from a bond. The “coupon” refers to the amount of money received, while the “coupon rate” refers to the interest rate that calculates the coupon. In our example, the coupon rate is 5% so the coupon itself is $5.
- Maturity date: The date upon which the investor will receive their principal back. Upon this date, the investor will have their initial investment returned to them, and no further interest payments will occur. Using our example, the maturity date is one year from the date of purchase.
- Par value: The bond’s principal amount. In our example, the par value of the bond is $100.
- Callable: If a bond is “callable,” it may be redeemed ahead of the maturity date by the issuer. Typically there are provisions in the bond documentation that detail any events that would permit the bond to be called. This will cease any further scheduled interest payments, and the issuer will usually have to pay a premium in order to compensate the investor. In our example, the issuer would have the right to essentially buy the bond back from the investor in exchange for $110 at any time before maturity is reached.
Bonds have several advantages. First is certainty. Bonds have a predetermined interest rate and maturity date. As such, investors know what their fixed income from the bond will be and generally when they can expect to receive their principal investment back. Another advantage is stability. While stocks can be quite volatile in their price fluctuations, bonds have a fixed return. One type of bonds, US Treasury Bonds, are among the safest investments available. Finally, some bonds can have tax advantages. Contact a qualified tax advisor for more information on potential tax advantages. Given their relative safety, a well-diversified portfolio will often contain bonds as a means to hedge risk.
From the preceding paragraph, bonds seem to be a great investment. Unsurprisingly, there are some drawbacks. A major drawback of bonds is inflation risk. Because bonds have a set interest rate, there is always the risk that inflation will strip bonds of their value given that the set payments might fall behind inflation. For example, if a bond’s annual interest rate is 5% but inflation occurs at 7%, the investor is losing money because his investment would have grown by an additional 2% had he done nothing with it. Another risk is credit risk. While bonds are among the safest investments, investors still face the risk of default. If default occurs, an investor’s principal could be lost and not repaid as expected at the maturity date. A third major type of risk is the interest rate risk. If the market interest rate grows over time above the bond’s coupon rate, it will no longer be an ideal investment as more money could be made in alternative investments. The longer the bond’s maturity, the greater this risk.
With this information, hopefully investors will come to know a little bit about bonds. Generally they provide a safer investment than stocks, but the potential for earnings is limited. While this post provides an overview, investors should consult other resources for more expansive information. The following is a list of some examples.